Colorado Real Estate Journal - March 2, 2016
Peter Wessel Seniors housing owner-operators have a number of choices in how they capitalize the acquisition, development and operation of their facilities. Choosing between various sources of equity versus debt involves several considerations: a) cost of capital, b) emphasis on ownership versus operations, c) predilection for risk and d) return on investment. Banks offering floating-rate debt generally offer the lowest cost of debt, however, bank loans tend to be lower leverage, shorter term and recourse. Lower leverage requires higher investment of equity, with higher yield requirements, thereby offsetting the nominal advantage of low-cost debt. Shorter terms expose owner-operators to interest rate and market risk upon loan maturity. Recourse provisions trigger personal or corporate guarantee exposure on the debt. On the other end of the spectrum are real estate investment trust sale-leaseback and other forms of participating or quasi-equity financing structures. These are more expensive sources of capital, but provide high leverage and may be best suited for seniors housing operators who desire to emphasize operations over real estate ownership as a business strategy. Federal Housing Administration-insured (U.S. Department of Housing and Urban Development) financing offers nonrecourse, high-leverage, fixed-rate debt financing to owner-operators who desire to maximize investment return in the real estate assets as well as operations. Although fixed-rate debt tends to carry a higher nominal interest rate than floating-rate debt, it eliminates interest rate risk. The high leverage of an FHA-insured loan means less equity is required, thereby bringing down the effective blended cost of capital. Michael Thomas Private equity and REITs have increased investment in the senior housing demographic based on the industry’s favorable risk-reward. Health care REITs now represent the fourth largest sector of equity REITs, comprising 11.3 percent of the market, following behind retail, residential and office. Senior housing continues to be bolstered by the retirement community’s industry revenue growth, predicted to accelerate in the next five years due to more retiring baby boomers. Industry value added (a measure of the industry’s contribution to the overall U.S. economy) is forecast to grow at 5.9 percent annually over the 10 years to 2020; gross domestic product is projected to grow only by 2.5 percent. While there are multiple lenders in the senior housing space, the HUD/FHA programs will remain a viable option for many developers. The new-construction program is the only one that offers a construction/permanent loan with no recourse and a fully amortizing, 40-year fixed-rate loan. Further, HUD has recently announced lower mortgage insurance premiums for certain affordable projects and also properties that meet a variety of energy standards. This drop is a significant savings to proposed projects that qualify. The other sources, such as bank financing and REITs, also will remain viable options. Banks are limited by “concentrations” defined as loans extended to a common industry or pool that may perform similarly and may not exceed 100 percent of their total risk-based capital. With all the rapid growth, this may result in some banks scaling back. Rob McAdams The growing appetite for stabilized, high-quality assets by publicly traded REITs has made it difficult for traditional private investors and owner-operators to invest directly in those properties. The public REITs benefit from a favorable tax structure and access to public markets, which yields them the lowest cost of capital. And they need cash flow to feed dividends. The private REITs, which have a higher cost of capital, are typically acquiring individual assets or small portfolios with the goal of aggregating sizeable portfolios that can be sold to public REITs. They’ll pursue “A” assets with upside if the public REITs aren’t bidding. The traditional private-equity players and owner-operators have patient, albeit more expensive, capital. Their higher return thresholds have steered them toward turnaround acquisitions with the potential for value creation. They’ve essentially been eliminated from the “A” asset buyer pool because REIT demand has caused cap rates to compress so low that it’s not possible for them to outbid the competition and hit their hurdle rates. With owner-operators and private equity still accounting for around 60 percent of merger and acquisition activity, demand for HUD/FHA financing and conventional loans remains strong. Because HUD/ FHA-enhanced financing allows investors to borrow on the credit of the U.S. government, there always will be private-sector demand for the attractive nonrecourse terms provided by that product. I expect to see a reduction in both volume and leverage from commercial banks as a result of increased banking regulations such as the high-volatility commercial real estate rule.